Underlying inflation at 4.3 per cent is at its highest in nearly 10 years, spurred by rises in import prices, housing rents and food costs. Analysts say it is heading towards 5 per cent and that could crimp household spending just as the economy is relying on consumption to offset weakening exports.

'The risk is that in coming quarters consumption growth will weaken due to higher prices coming through and because an export downturn will affect Hong Kong and firms will have to scale back hiring,' said Mr Rob Subbaraman, Lehman Brothers' Asia economist.

For now, consumption is robust.

Real interest rates are negative and wages are strong, while the stock market's 39 per cent rise last year created a wealth effect. Private consumption rose 10 per cent in the fourth quarter from a year before, driving a 6.7 per cent rise in gross domestic product.

But the stock market has fallen 20 per cent so far this year and export growth is weakening as shipments to the United States, the biggest market after China, have fallen in recent months.

The government and many economists believe Hong Kong's links with China's economy will provide a cushion. They forecast growth in Hong Kong of 4 to 5 per cent this year - down from an average 7.2 per cent in the past four years, but decent, all the same.

Yet not everyone is so optimistic.

Mr Sean Yokota, an economist at UBS, forecasts just 2.5 per cent growth this year, even though he expects a United States recession to be over by the second half.

'China will provide a cushion, yes. But an export slowdown will filter through and derail consumption and investment,' Mr Yokota said.

He estimates that earnings from exports equal 32 per cent of gross domestic product: the value of exports is more than 200 per cent of GDP but they are mostly re-exports. And the trade sector accounts for 15 to 20 per cent of total employment.

In 2001, Mr Yokota points out, 8 per cent growth in China didn't save Hong Kong from recession when the dotcom bubble burst.

Analysts do not expect a recession this time, but Credit Suisse says Hong Kong is especially vulnerable to a global slowdown and that its 4.6 per cent growth forecast for 2008 could be cut to 2.1 per cent if there is a slump in the United States, Japan and Europe.

Currency pressures
Hong Kong's currency regime may add to the complications.

The Hong Kong dollar is pegged to the US dollar and its interest rates track US rates.

More US rate cuts could keep downward pressure on the US dollar - which hit record lows against European currencies and a 12-year low against the Japanese yen this week - and upward pressure on Hong Kong import prices.

That has reignited speculation the peg may eventually have to go in order to stifle imported inflation, although officials have stressed repeatedly there is no need for change.

For consumers, rate cuts help but price rises will start to bite.

Headline inflation is just 3.2 per cent thanks to a government waiver on property rates. But housing rents are rising by 30 per cent in many cases on renewal of two-year leases. Food price inflation is running at 16 per cent and prices of everything from package tours to taxi fares have shot up recently.

Wages are forecast to rise only 4-5 per cent this year, and economists say unemployment, at a 10-year low of 3.4 per cent, could head higher if a weak US economy triggers lay-offs in trade or finance, the biggest contributors to GDP.

Mr Tse Kwok Leung, senior economist at Bank of China (Hong Kong), remains upbeat.

'China's economy will grow by around 10 per cent this year. That will help tourism and consumption in Hong Kong and a number of Chinese companies are waiting to list in Hong Kong,' he said.

Rapid growth in tourism from China helped Hong Kong retail sales reach a record US$32 billion (S$44 billion) last year while the lucrative business of handling new Chinese share issues is creating jobs and boosting wages in the financial sector.

However, after 37 months of uninterrupted growth, a purchasing managers' survey showed activity at manufacturing and service companies stagnated last month as orders from China and elsewhere stalled, prompting firms to hold off hiring.

'According to the PMI survey, Hong Kong will suffer falling export growth in coming months and household spending will receive weaker support from employment,' Citigroup said in a research note.

Only one month's data, but Citigroup said it signalled the economy faced its biggest challenge since the scare over Severe Acute Respiratory Syndrome (Sars) triggered recession in 2003. -- REUTERS